The Value of the Rupee Is Often Influenced by Trends in the Yen

Newcomers to trading foreign currencies are immediately astounded by the enormous amount of information that must be assimilated daily. Currencies do not trade in a vacuum. In today’s modern era of globalization, currencies are the “fulcrum points” upon which global commerce teeters to and fro. Currencies come in pairs, and any information, fundamental or technical, that can impact either country’s economy in any way must be taken into account by a forex trader or he risks an unanticipated financial setback in the market.

Currency brokers and traders alike attempt to stay abreast of every correlation in the market that might suggest a potential trend in the making. Fundamentals do move the currency market, but often it is a combination of many factors that produce a noticeable change in direction, making it difficult to pinpoint the actual details leading to the shift. The value of the Rupee has declined some 20% in the past ten months for a number of reasons, but tracking its correlation to the Japanese Yen is one way to gain insights into what might happen next.

The following diagram illustrates this market relationship between the Rupee and the Yen over the past two years:

Much has been written about the ongoing success story in India. Over the past four decades, the nation has benefited from corporations in developed economies in the West “off shoring” various activities to Indian enterprises due to low labor costs, favorable legal infrastructure, and low government corruption. GDP growth over he period has been significant, and although present forecasts may be 5.2% for 2012, there is not a developed economy in the world that would not be happy with this figure. In India, however, this figure represents a material decline from years past. Inflation and slower growth are now true concerns, and the value of the Rupee has fallen as a result.

What is the correlation with the Yen all about? As a developing economy, Indian investors must accept the vagaries of the “carry trade” in today’s world of global investing. International banks, corporations, and investors often borrow funds in a low interest environment and then invest them where potential returns are higher. The Yen and the U.S. Dollar are typically the “carry” currency in this scenario, due to their near zero interest rate postures at the moment. The investment side of the transaction has often been in Indian securities, due to their potential for high returns.

The “carry trade” scenario works fine as long as relative currency valuations remain constant or the rate for the target country, in this example India, appreciates. When the local currency appreciates, the investor reaps two rewards – the return on his security and a bit extra from the better exchange rate when funds are repatriated. While the first half of the chart illustrates favorable conditions, the past year reflects how quickly capital flows can reverse in today’s electronic trading environment.

The first “Divergence” occurred following the earthquake in Japan and the political strife in Europe. In both cases, funds were repatriated back to their respective homelands, causing a massive shift in “carry trade” positions, especially in India. As the Yen strengthened, the Rupee fell. An increase in domestic interest rates by the RBI reversed this trend, causing a brief “Convergence”, but a “double-dip” recession in the majority of countries in the Eurozone has created a more “Risk-Off” mentality to grip the minds of the investment community.

At present, another divergence has taken place. What is a likely scenario for the future? A weaker Yen may yet cause another convergence. Stay tuned.